Monday, 21 November 2011

Has the Hard Default Arrived?

On October 27th, George Papandreou returned from Brussels having participated in an all-night negotiation session which resulted in a PSI agreement of EUR 100 billion (pending bank acceptance) and a second bail-out package for Greece worth EUR 130 billion (of which EUR 30 billion was actually part of the PSI agreement).

Today, on November 20st, nearly a month has gone by with George Papandreou being forced from office over his absurd referendum plans, a government of national disunity in place, and the contagion of the European sovereign debt crisis now affecting core Eurozone economies. Recent Italian and Spanish bond rates were above 6.5%, despite extensive European Central Bank purchases. Interest spreads of French and Dutch sovereign bonds rose last week. Perhaps most critically, recent offerings of European Financial Stability Fund (EFSF) bonds were cancelled due to poor market sentiment. Given that the EFSF must raise at least a further EUR 250 billion, it is difficult to see how this will occur.

The financial markets remain dominated by risk-averse thinking, which is quite reasonable given the current situation:

a.Banks are forced to write down EUR 100 billion in Greek debt (the 50% PSI) while at the same time raising core capital ratios to levels which imply a further EUR 100-150 billion in new capital.

b.The Greek PSI of 50% is far higher than what the industry was willing to accept, and creates justifiable fears of moral hazard with other highly-indebted countries, in terms of both private and sovereign debt.

c.Non-performing loans are rising across the Eurozone, led by commercial and household real estate loans. The next step will be a decline of prime real estate values in France and the UK, accelerating the negative feedback loop.

d.Core economic indicators in Europe and Asia continue to deteriorate. In Europe, this is due to government austerity, private and corporate deleveraging, and declining consumer spending.

e.The ratings agencies are in a risk-averse mode, with banks across Europe being downgraded, and several countries (including France) at risk of losing their current ratings status.

Given these factors, the spectre of a hard Greek default can therefore no longer be ignored in the short term. In the longer term, it remains to be seen whether the second bail-out and PSI will actually be implemented.

1. The Sixth Instalment will meet less than 2 months cashflow requirements

Greece is focussing on the 6th instalment of the original bail-out package, as the public sector has run out of funds. Salaries have not been paid; suppliers are unpaid as well. However, the 6th instalment of EUR 8 billion will not be sufficient to cover Greece’s urgent funding needs, which include bond refinancing of EUR 6 billion in December and EUR 3 billion in January, in addition to a salary arrears of at least EUR 1 billion and higher-than-usual December salaries and pensions. The government has official arrears of EUR 6 billion; unofficially these are higher.

While the government is betting on higher-than-normal tax revenue at the end of the year, all previous months have shown that actually revenue income is typically lower than forecast.

2. It is not certain that the Second Bail-out can be implemented

It now seems extremely difficult that the second bail-out, of EUR 130 billion, can actually be implemented. This funding must be approved by the Parliament of each Eurozone member, a process that will likely be completed by February 2012 under normal circumstances. However, the capital remains to be raised in financial markets. Normally, this would be done by issuing a sovereign guarantee and turning to markets.

But the original bail-out includes an important proviso: that if national conditions are such that raising funds is impossible at rates below those offered to Greece (which then was 5%), these countries may opt-out of the bailout. Spain and Italy currently fall into that category, as do Portugal and Ireland (which have already opted out of future debt participation for Greece).

It is currently impossible to forecast whether the remaining EUR 130 billion can actually be raised, in no small part because it must be raised from the very same financial institutions who have been strong-armed into a EUR 100 billion write-down of Greek debt, and who are being asked to raise core capital ratios. And who face ratings downgrades as a result of their exposure to Greek, Italian, Spanish and other debt.

Much depends on capital markets between now and Christmas. The trends are negative, and worsen due to the US Supercommittee’s inability to make further cuts to US debt before triggering the automatic debt cuts. With elections in the United States and France in 2012, debt and austerity have become hopelessly politicised.

In Greece, meanwhile, the country is paralyzed by Mr. Samaras’ refusal to sign a letter agreeing to the October 26th (27th) agreement. Mr. Samaras may find that by the time his ego allows him to sign the letter, the train of European solidarity has already left the bail-out station.

Given the collective irresponsibility of the Greek political class, a default may be the only rational option left.

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